ISO vs NSO: Key Differences, Explained

ISO vs NSO: Understanding the key differences

What is ISO and NSO, understanding the key differences between these two types of stock options, and knowing which one to use for your startup

Startup Equity Experts

Jun 2, 2026

Last update

Table of Contents

What are stock options?

Stock options give the holder the right (but not the obligation) to buy shares in a company at a fixed price (the strike price, also called the exercise price) at some point in the future.

The value comes from the spread: if the company grows and shares become worth more than the strike price, the option holder can buy at the lower price and potentially sell at the higher one.

Incentive Stock Options (ISOs)

ISOs are defined under Section 422 of the Internal Revenue Code. They are available to employees only and offer preferential federal tax treatment: no ordinary income tax at exercise, and long-term capital gains rates at sale if holding period requirements are met. In exchange for that tax advantage, ISOs come with stricter rules around eligibility, grant limits, and exercise windows.

Learn more about Incentive Stock Options.

Non-Qualified Stock Options (NSOs)

NSOs are the more flexible option type. They can be granted to employees, contractors, advisors, and board members, with no restriction on grant size and simpler compliance requirements. The tradeoff: the spread at exercise is taxed as ordinary income, with no deferral benefit.

Learn more about Non-qualified Stock Options.

ISO vs NSO Comparison

ISO NSO
Who can receive Employees only Employees, contractors, advisors, board members
Tax at exercise No ordinary income tax (but AMT applies) Ordinary income tax on the spread
Tax at sale Long-term capital gains (if holding periods met) Capital gains on post-exercise appreciation
AMT exposure Yes — spread at exercise is an AMT preference item No
Company tax deduction No deduction on qualifying dispositions Deduction equal to employee's income at exercise
409A requirement Yes Yes
$100K annual limit Yes — excess above $100K/year becomes NSO No limit
Post-termination window 90 days to exercise as ISO (then converts or lapses) Typically 90 days, but can be extended by company
Transferability Cannot transfer except at death Generally non-transferable, but more flexible
Entity type C-corps and S-corps only Any entity type

ISO vs NSO: Who can receive them?

The most fundamental difference between ISOs and NSOs is eligibility.

ISOs can only be granted to current employees.

Contractors, advisors, board members, and consultants are not eligible, regardless of how closely they work with the company.

NSOs have no such restriction. They can go to anyone providing services.

Full-time employees, part-time employees, contractors, advisors, and board members—all eligible for an NSO.

"NSOs are by far the most flexible type of stock options. You can grant it to an employee and non-employee, like an independent contractor. An ISO can only be granted to an employee, so there's like one restriction. An NSO has a lot more flexibility for startups when cash might not always be available to pay your bills." —Matt Secrist, Partner at Taft Law

The practical rule: any grant to a non-employee must be an NSO. ISOs are only on the table when the recipient is on payroll.

There are additional ISO-specific constraints beyond eligibility:

"You don't see ISO too much in the startup world. The reason I say you don't see it that much is because it's a little more complicated. There's a lot more bells, there's a lot more regulation versus NSOs." —Matt Secrist

ISO vs NSO: How are they exercised?

Exercising stock options means paying the strike price to convert your option into actual shares — the process, timing, and tax consequences vary depending on whether you hold ISOs or NSOs.

Both ISOs and NSOs follow a vesting schedule before they can be exercised. Vesting conditions are set out in the option agreement or offer letter and are typically time-based or milestone-based.

Exercising ISOs

Under IRS rules, ISOs must be exercised within 10 years of the grant date (7 years for shareholders holding more than 10% of the company). They must also be exercised within 90 days of leaving employment to retain ISO tax treatment. After that window, any unexercised ISOs either lapse or convert to NSOs, depending on the plan.

Exercising NSOs

NSOs do not have a fixed expiration date under federal tax law, though company plans typically impose one. Like ISOs, NSOs are subject to a post-termination exercise window on departure, usually 90 days, though companies can extend this window at their discretion.

Cashless exercise is available for NSOs in some cases. This means, rather than paying the strike price in cash, the holder sells a portion of shares at exercise to cover the cost. This requires company approval, so option holders should confirm with the plan administrator before assuming it's available.

ISO vs NSO: How are they taxed?

Tax treatment is where ISOs and NSOs diverge most significantly.

ISOs: The qualifying scenario

When an employee meets both holding period requirements (at least 2 years from grant date and at least 1 year from exercise date), ISOs receive preferential federal tax treatment:

At grant: No tax event.

At exercise: No ordinary income tax. The spread is not taxed as income (though it is an AMT adjustment).

At sale: The full gain from strike price to sale price is taxed at long-term capital gains rates.

Example: holding period met

In this case:

ISOs: disqualifying dispositions

If shares are sold before the holding periods are met, it becomes a disqualifying disposition. The spread at exercise is taxed as ordinary income, and any further gain is taxed as short or long-term capital gains depending on how long shares were held post-exercise.

NSOs: tax treatment

NSOs are taxed at two points: exercise and sale.

ISO vs NSO: AMT exposure

AMT is a parallel tax system that runs alongside regular federal income tax. You calculate your liability under both systems and pay whichever is higher.

ISO exercises create an AMT preference item. The spread at exercise is added to AMT income even though it isn't taxed as ordinary income. If your total AMT income crosses the exemption threshold, you may owe AMT in the year of exercise with no corresponding cash from a sale.

AMT planning strategies

California state tax

California does not conform to federal ISO preferential tax treatment. Under California law, the spread at ISO exercise is taxed as ordinary income at the employee's California marginal rate, regardless of whether federal holding periods are met.

409A requirements

Both ISOs and NSOs share one compliance requirement: the strike price must equal or exceed the 409A FMV at the time of grant.

ISO vs NSO: Post-termination exercise window

The post-termination exercise window (PTE) is one of the most consequential but least communicated parts of any equity plan.

For ISOs: IRS rules require exercise within 90 days of leaving employment.

For NSOs: the post-termination window is set by the company plan.

ISO vs NSO: How to choose?

Scenario 1: Granting to your first advisor - Use NSOs.

Scenario 2: Early full-time engineering hire - ISOs are worth considering.

Scenario 3: Series A, granting to VP of Sales - Consider a mix.

Scenario 4: Non-US team member - Use NSOs.

Scenario 5: Contractor converting to full-time employee - Generally no.

Frequently Asked Questions

What is the main difference between ISOs and NSOs?

Can advisors receive ISOs?

Do ISOs avoid AMT?

How does California treat ISO exercises?

What happens to ISOs when an employee leaves?

Which is better: ISOs or NSOs?

Do both ISOs and NSOs require a 409A valuation?

What is a disqualifying disposition?

Wrapping up

Most of the complexity around ISOs and NSOs comes down to a few core questions: who is receiving the grant, what's the spread likely to be at exercise, and where does the recipient live?

What matters most is not which type you choose, but that your team understands what they have, what it means at each stage, and when they should talk to a tax advisor before they act.